Opportunity Cost

The Next Best Alternative

The Opportunity Cost of doing something is the value of the next best

alternative you give up.

What is the opportunity cost of investing $500 in a new stereo system?

What is the opportunity cost of going to college?

Opportunity cost varies from person to person

What would you have purchased if you did not purchase the $500 stereo system?

What could you “earn” if you don’t go to college

When we use resources to produce one good or

service, the opportunity cost is that we cannot

produce another good or service.

When we make birdcages, we cannot use the same resources to make chairs.

How do you get an A in this class?

Of course, hard work and fulfilling requirements

If you are unable to achieve an A by fulfilling requirements, you may be able to buy one.

The going rate is one million dollars

How do individuals or groups determine which

specific goods or services to produce?

Law of Comparative Advantage

The individual (or country) with the lowest opportunity cost of producing a particular good should specialize in producing that good.

Specialization – The concentration of the productive efforts of individuals and firms on a limited number of activities

Babe Ruth

Opportunity cost is the key to comparative advantage: Individuals and nations gain by producing goods at relatively low costs and exchanging their outputs for different goods produced by others at relatively low cost. All potential trading partners can gain enormously through appropriate specialization and exchange.

Comparative & Absolute Advantage

Comparative Advantage:

The ability to produce something at a lower opportunity cost than other producers face

Absolute Advantage:

The ability to produce something with fewer resources than other producers use

Opportunity Costs and Efficiency

Before Specialization Hours Worked Production and Consumption

Alaskan 4

4

5 pounds of salmon

1 pound of coffee

Brazilian 4

4

1 pound of salmon

5 pounds of coffee

After Specialization

Hours Worked

Production Consumption

Alaska 8 10 pounds Salmon 5 pounds of salmon

5 pounds of coffee

Brazilian 8 10 pounds Coffee 5 pounds of coffee

5 pounds of salmon

Suppose, for example, that a lawyer whose fees run $250 an hour types twice as fast as her secretary, whose wage is $12

hourly. She still gains by hiring the secretary. Despite her absolute

advantage in typing, the lawyer’s comparative advantage lies in

practicing law.

Comparative Advantage in Early America

“Cash crops did not grow well in the Northern soil and climate. Southerners, on the other hand, had begun to reap huge profits from cotton by the mid-1790s. The South had very little incentive to industrialize. As a result, the North and South continued to develop two distinct economies, including very different agricultural systems.”

---The Americans

Comparative Advantage in Early America

•Northern Comparative Advantageo Industry

•Southern Comparative Advantageo Mass Cotton and Tobacco Production

Other Economic Principles in Early America

•Cost-Benefit Analysis of Slavery• Opportunity Cost: Value of the next best alternative

o North: Chose no slavery • Assume slavery (owning the laborer) is next best

alternative to wage labor (renting the laborer).o South: Chose slavery

• Assume wage labor is next best alternative to slave labor

• Question: Why did the benefits of the choice exceed the opportunity cost?

Other Economic Principles in Early America

•Factors influencing choice of labor typeo Relatively high wages in America

Made renting labor expensive everywhereo Fixed costs of overseeing and possessing slaves

Larger firm size lowers average fixed cost Minimum average cost for slave production occurs at

larger firm size. o Climate and market differences promoted large firm size in

South and small firm size in North.

Other Economic Principles in Early America

•Trade is mutually beneficialo Northern farmers traded with Northern

manufacturerso Facilitated growth of Northern industryo Relative wealth in industry ownership

o Southern farmers traded with European manufacturerso Facilitated growth of Southern plantation systemo Less industrial growth in Southo Relative wealth in plantation ownership

o Beneficial trading was separating North and South

Other Economic Principles in Early America

•“American System”o Tariff in 1816 on imported manufactured goods

from Europe Designed by President Monroe to make North and

South more interdependent Lobbied for by Northern Manufacturers

o Ushered in the “era of good feelings” Circular Flow of Income and Expenditure One person’s spending becomes another’s income

Other Economic Principles in Early America

•Restricting Tradeo Common Incentive:

o Shift the mutually beneficial trade my wayo Limit my competitors

o Tariff of 1816o Shifted South-Europe trade to South-North

tradeo Strengthened Northern Manufacturing

Influenced outcome of Civil War

Illustrating Comparative Advantage

•A Tootsie Roll Game• Ignore absolute advantage to keep things as

simple as possible

•Five “points” to use in production• Country A: Twice as productive at producing

cherry tootsies.• Country B: Twice as productive at producing

cherry tootsies.

Illustrating Comparative Advantage

Country A: Production Possibilities Using Your 5 Points

Your Choice?Allocation of Points Production Possibilities

Points UsedTo ProduceCHERRY

Points UsedTo ProduceORANGE

CHERRY TootsiesProduced

ORANGETootsiesProduced

A 0 5 0 5

B 1 4 2 4

C 2 3 4 3

D 3 2 6 2

E 4 1 8 1

F 5 0 10 0

Illustrating Comparative Advantage

Country B: Production Possibilities Using Your 5 Points

Your Choice?Allocation of Points Production Possibilities

Points UsedTo ProduceCHERRY

Points UsedTo ProduceORANGE

CHERRY TootsiesProduced

ORANGETootsiesProduced

A 0 5 0 10

B 1 4 1 8

C 2 3 2 6

D 3 2 3 4

E 4 1 4 2

F 5 0 5 0

Illustrating Comparative Advantage

• Which production combination did you choose?

• Cherry _________• Orange _________

Illustrating Comparative Advantage

• Trading Opportunityo Would you like to replay the game?

Produce first Then trade

One cherry for one orange, or One orange for one cherry

Illustrating Comparative Advantage

•For Replay of the Game: •Which production combination did you choose?

• Cherry _________• Orange _________

•After trade combination?• Cherry _________• Orange _________

Practice:

Under current conditions, we can produce either 120 autos OR 3 aircraft, therefore: 120A = 3 B.Dividing both sides by 3 yields: 120/3 = 3/3 or 40A = 1B40A = 1B is the number of autos given up to produce one aircraft or the opportunity cost of one aircraft

To Find Which Nation has the Comparative

AdvantageFind opportunity costs for both nationsCompare each product’s opportunity cost from nation to nationNation with the lowest opportunity cost has the comparative advantageIf U.S. has 1A=.025B & G.B. has 1A=.05B, who has the comparative advantage?

Importance of Comparative AdvantageTo benefit from free trade, a nation does not have to be the lowest cost producer in the worldA nation only has to have the lowest opportunity costRemember, opportunity cost is what you give up to do somethingUse all the world’s resources in the relatively most productive ways

Where did this theory Originate?

David Ricardo

See separate bio and examples.